Accounting Cycle


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Accounting Cycle

  1. 1. Accounting CycleThe Fundamentals of Accounting Ahmad Tariq Bhatti FCMA, FPA, MA (Economics), BSc Dubai, United Arab Emirates
  2. 2. ACCOUNTING CYCLE Detailed ContentsUNIT 1: ACCOUNTING CYCLE _______________________________________________ 7 1.1 Assumptions of financial accounting ____________________________________________ 7 1.2 Characteristics of financial accounting & reporting information _____________________ 7 1.3 Principles of financial accounting & reporting ____________________________________ 8 1.4 Book-keeping versus accounting ______________________________________________ 10 1.5 Introduction to an account ___________________________________________________ 11 1.6 Rules for increasing & decreasing accounts _____________________________________ 11 1.7 Accounting equation ________________________________________________________ 12 1.8 Types of accounting entries___________________________________________________ 12 1.9 Normal account balances ____________________________________________________ 12 1.10 Income statement accounts ___________________________________________________ 12 1.11 Balance sheet accounts ______________________________________________________ 12 1.12 Classifying balance sheet accounts _____________________________________________ 13 1.13 Classifying income statement accounts _________________________________________ 13 1.14 Chart of accounts ___________________________________________________________ 13 1.15 The flow of data ____________________________________________________________ 14 1.16 The two column journal _____________________________________________________ 14 1.17 Three-column & four-column accounts _________________________________________ 14 1.18 The trial balance & errors ___________________________________________________ 15 1.19 Matching revenues & expenses________________________________________________ 15 1.20 The adjustment process ______________________________________________________ 16 1.21 Prepaid expenses - adjustments _______________________________________________ 16 1.22 Non-current assets - adjustments ______________________________________________ 16 1.23 Liabilities - adjustments _____________________________________________________ 16 1.24 Work sheets & financial statements ____________________________________________ 16 1.25 Preparing financial statements ________________________________________________ 17 1.26 Journalizing & posting closing entries __________________________________________ 17 1.27 The accounting cycle ________________________________________________________ 17 (1/48)
  3. 3. ACCOUNTING CYCLE 1.28 The final product of book-keeping and accounting _______________________________ 18UNIT 2: ACCRUALS & DEFERRALS __________________________________________ 19 2.1 Introduction _______________________________________________________________ 19 2.2 Deferrals - prepaid expenses __________________________________________________ 19 2.3 Deferrals - unearned revenues ________________________________________________ 20 2.4 Accruals - liabilities or expenses _______________________________________________ 22 2.5 Accruals - assets or revenues _________________________________________________ 22 2.6 Reviewing accruals and deferrals ______________________________________________ 23UNIT 3: ACCOUNTING SYSTEMS ____________________________________________ 24 3.1 Principles of accounting systems ______________________________________________ 24 3.2 Installing & revising accounting systems________________________________________ 24 3.3 Internal controls____________________________________________________________ 25 3.4 General Ledger ____________________________________________________________ 25 3.5 Subsidiary Ledgers _________________________________________________________ 25 3.6 Difference between General Ledger & Subsidiary Ledger _________________________ 25 3.7 Special Journals ____________________________________________________________ 26 3.8 Purchases Journal __________________________________________________________ 26 3.9 Cash Payments Journal ______________________________________________________ 26 3.10 Sales Journal ______________________________________________________________ 27 3.11 Cash Receipts Journal _______________________________________________________ 27 3.12 The voucher system _________________________________________________________ 27 3.13 Types of vouchers __________________________________________________________ 27 3.14 Important facts about vouchers _______________________________________________ 28 3.15 Facts about a Voucher Register _______________________________________________ 28 3.16 Voucher files procedures _____________________________________________________ 28 3.17 Using a Check Register ______________________________________________________ 29 3.18 Year end __________________________________________________________________ 29UNIT 4: CASH& BANK ______________________________________________________ 30 4.1 Bank accounts _____________________________________________________________ 30 4.2 Bank statements ____________________________________________________________ 30 (2/48)
  4. 4. ACCOUNTING CYCLE 4.3 Bank reconciliations ________________________________________________________ 30 4.4 Bank reconciliations statements _______________________________________________ 30 4.5 Cash accounts ______________________________________________________________ 31 4.6 Internal controls for cash accounts ____________________________________________ 31 4.7 Electronic funds transfer ____________________________________________________ 31UNIT 5: RECEIVABLES _____________________________________________________ 32 5.1 Introduction _______________________________________________________________ 32 5.2 Receivable controls _________________________________________________________ 32 5.3 Calculating interest _________________________________________________________ 32 5.4 Accounting for notes receivable _______________________________________________ 32 5.5 Discounting a note receivable _________________________________________________ 33 5.6 Dishonored notes receivable __________________________________________________ 33 5.7 Receivable balances which become uncollectible _________________________________ 33 5.8 Methods used to estimate uncollectible balances _________________________________ 33 5.9 The allowance method _______________________________________________________ 34 5.10 The direct write-off method __________________________________________________ 34UNIT 6: INVENTORIES _____________________________________________________ 35 6.1 Inventory & financial statements ______________________________________________ 35 6.2 Inventory accounting systems _________________________________________________ 35 6.3 Determining inventory quantities & costs _______________________________________ 35 6.4 Inventory costing methods - periodic ___________________________________________ 35 6.5 Comparing inventory costing methods _________________________________________ 36 6.6 Using non-cost methods to value inventory ______________________________________ 36 6.7 Periodic versus perpetual inventory systems ____________________________________ 36 6.8 Inventory costing methods - perpetual _________________________________________ 37 6.9 Methods used to estimate inventory cost ________________________________________ 37 6.10 IAS 2 application ___________________________________________________________ 37UNIT 7: NON-CURRENTASSETS _____________________________________________ 38 7.1 Introduction _______________________________________________________________ 38 7.2 Depreciation _______________________________________________________________ 38 (3/48)
  5. 5. ACCOUNTING CYCLE 7.3 Determining depreciation ____________________________________________________ 38 7.4 Straight-line method ________________________________________________________ 38 7.5 Units-of-production method __________________________________________________ 39 7.6 Declining-balance method ____________________________________________________ 39 7.7 Sum-of-the-years-digits method _______________________________________________ 39 7.8 Composite-rate depreciation method ___________________________________________ 39 7.9 Comparing depreciation methods _____________________________________________ 39 7.10 Depreciation & income taxes _________________________________________________ 40 7.11 Revising depreciation estimates _______________________________________________ 40 7.12 Recording depreciation expenses ______________________________________________ 40 7.13 Capital & revenue expenditures _______________________________________________ 40 7.14 Disposing fixed or non-current assets __________________________________________ 40 7.15 Trade-in of fixed assets ______________________________________________________ 41 7.16 Subsidiary Ledgers for non-current assets ______________________________________ 41 7.17 Fixed Assets Register ________________________________________________________ 41 7.18 Leasing tangible non-current assets ____________________________________________ 41 7.19 Intangible assets ____________________________________________________________ 42 7.20 Depletion __________________________________________________________________ 42 7.21 IAS 16 property plant & equipment application _________________________________ 42UNIT 8: PAYROLL SYSTEM _________________________________________________ 43 8.1 Introduction _______________________________________________________________ 43 8.2 Profit-sharing bonuses_______________________________________________________ 43 8.3 Employee earnings deductions ________________________________________________ 44 8.4 Employers payroll tax liabilities ______________________________________________ 44 8.5 Payroll accounting systems ___________________________________________________ 44 8.6 Components of the payroll system _____________________________________________ 44 8.7 Payroll system controls ______________________________________________________ 45 8.8 Liabilities for employee fringe benefits _________________________________________ 45 8.9 IAS 19 & IAS 26 application__________________________________________________ 45UNIT 9: THE GOING CONCERN ASSUMPTION ________________________________ 46 (4/48)
  6. 6. ACCOUNTING CYCLE 9.1 Definition & its Explanation __________________________________________________ 46 9.2 Examples of indicators of going concern problems _______________________________ 46 9.3 Examples of mitigating factors ________________________________________________ 47APPENDIX A: HOW TO CREATE & MAINTAIN A FIXED ASSET REGISTER _______ 48 (5/48)
  7. 7. ACCOUNTING CYCLE OBJECTIVESThe principles of accounting Identify the characteristics of financial accounting and reporting information. Understand the underlying principles, bases, tenets, assumptions for financial statements. Recognize the advantages of applying the fundamentals of accounting. Understand the difference between book-keeping and accounting. Understand the process of recording for a transaction. Identify and learn to apply which of the 3 account types, asset, liability, and owners equity, are affected in a given transaction. Apply the accounting equation in given the accounts. Determine whether accounts are recorded as a debit or credit in a given transaction. Understand the importance and application of the Going Concern Assumption (GCA).Accounting records Thoroughly understand the accounting system and the various record books. Recognize the advantages of maintaining accounting records. Match source documents to examples of their transactions. Determine the correct entries of given transactions in a general journal. Perform posting procedures to a General Ledger. Perform the steps to taking a trial balance. Identify the techniques for locating errors. Understand the application of deferral and accruals.Preparing financial statements Recognize the importance and process of preparing proper financial statements. Learn how to prepare financial statements from a Trial Balance. Identify revenue and expense accounts. Prepare profit and loss account (also known as statement of earnings) Prepare a balance sheet (also known as statement of financial position) from a Trial Balance. Identify a cash transaction as an operating activity, investing activity, or financing activity.Important components of financial accountingUnderstand the system of managing and recording the following: Cash & Bank, Receivable Balances, Inventory, Non-current assets, Payroll systems. (6/48)
  8. 8. ACCOUNTING CYCLE UNIT 1: ACCOUNTING CYCLE1.1 Assumptions of financial accounting All book-keeping and accounting is based on some well-defined and universally accepted principles. They are alternatively named in the accounting literature. Some names are given as below:  Postulates  Doctrines  Concepts  Conventions  Tenets  Principles  Bases  Assumptions Brief description of these fundamental principles and their underlying characteristics is given in the below paragraphs:1.2 Characteristics of financial accounting & reporting information  Relevance Information provided by an Accounting System must be pertinent to the financial status and performance of the company.  Understandability To be useful, accounting information should be understandable to its users. Proper means of communication, including use of terminology, generally accepted lay-out of the financial statements, adherence to professional and industry disclosure requirements enhances the acceptability of the information presented in the financial statements.  Verifiability All the accounting information should be verifiable for the genuineness.  Objectivity Accounting information should be neutral in the sense that data are not manipulated to favour one party over another. This concept includes that all transactions will be recorded on the basis of objective evidence (i.e. invoices, receipts, bank statements, cheques etc.). For instance, a report is said to be objective, when two or more accountants arrive at same answer to an accounting query. (7/48)
  9. 9. ACCOUNTING CYCLE  Matching For any period in which revenue is recognized, expenses incurred in obtaining that revenue should also be recognized. For instance, sales price of merchandise is matched with its cost on sale to third party.  Timeliness For information generated by the accounting system to be useful for decision – making, it must be received by the stakeholders soon after the close of the financial year. Any delay in producing and presenting of financial statements would badly affect the decision making capability of the company. It is because of this principle that all companies’ laws in the world provide time frame for the production and presentation of this information.  Consistency This principle refers to the use of the same accounting method from one reporting period to another, so that proper evaluation could be possible over the periods of time.  Comparability Financial reports/statements must be presented in a form that permits comparison with other companies in the industry on equal basis. For instance, if all companies in an industry apply IFRSs/IASs in the preparation of their financial statements, their comparison can be made easily.1.3 Principles of financial accounting & reporting  Disclosure All information which would influence the assessment of the company’s health by outsiders should be disclosed in the financial statements.  Conservatism/ Prudence This principle can be understood from the following, ‘Record all losses when incurred and defer all gains until they are realized’.  Separate Entity Concept Business accounting and reporting is separate from the other personal properties and other businesses of the owner.  Continuity/Going Concern Assumption (GCA) The business is assumed to continue its operations for indefinite periods. [Refer to the detail at Unit 9]  Stable Monetary Unit (SMU) It is assumed that prices remain constant over time. Financial Statements are prepared from historical cost rather than on current values of assets. (8/48)
  10. 10. ACCOUNTING CYCLE Accounting PeriodThis concept refers to the time span over which accounting information is presented tothe stakeholders in the form of financial statements. It also refers to the periodicityconcept, which says financial statements are to be presented on periodic basis, mostly onQuarterly or Annual basis. Money MeasurementAll transactions are expressed in terms of a monetary unit of a country, the company isoperating. All financial statements are presented in the currency of the country, which isalso known as reporting currency. For instance, all companies working in UAE recordtheir transactions in Dirham and all companies working in USA use Dollar as theirreporting currency. Substance over FormIt is an accounting concept where the entity is accounting for items according to theirsubstance and economic reality and not merely on their legal form. This concept is oneof the key determinants of reliable information. For most transactions there will be nodifference, so no issue arises. In some cases however, the two diverge and the choice ofhow to present the transactions can give very different results. This difference occurswhen an asset or liability is not recognized in the accounts even though benefits orobligations may result from the transaction, or oppositely. For instance, a contract foracquisition of an asset that is legally a lease may, in fact, equivalent to purchase. To moreelaborate this example, a company acquired an asset through lease arrangement andagreed to make annual lease payments. Though on papers this is a lease of the asset but ineconomic substance and financial reality it is acquisition of the asset. The company aftermaking a nominal payment to Lessee Company can acquire the asset. Since the leaseterm covers substantial part of the life of the leased asset.Here the economic substance of the transaction is Purchase rather than Lease; thereforeits depreciation will be booked instead of showing rental expense in Profit & LossAccount.Remember this line: Accountants record a transaction’s economic substance ratherthan its legal form. MaterialityAccountants record only those events that are significant enough to justify the usefulnessof the information. Technically speaking, each time a sheet of paper is used, the currentasset, ’Office Supplies’ is decreased by an infinitesimal amount but the transaction is notmaterial enough to be recorded and accounted for. So this transaction is immaterial fromaccounting point of view and is not booked. Only material transactions are recorded. (9/48)
  11. 11. ACCOUNTING CYCLE  Dual Aspect This concept is the basis of the fundamental accounting equation, which is: Assets = Liabilities + Capital According to this concept every business transaction has two recording aspects. One is known as Debit (Dr.) and the other is known as Credit (Cr.). This concept is the foundation of Double Entry book-keeping. It is because of this concept that the two sides of a balance sheet always agree.  Historical Cost Convention Historical cost convention is that assets are recorded at their initial cost and are not subsequently revalued upwards, and liabilities valued at the amount initially received in exchange for the obligation. The relevance of the convention is that figures remain objectively based on verifiable conditions, but in times of high inflation historical cost can become a dubious convention to follow.  Cash Basis versus Accrual Basis of Accounting The Cash basis of accounting recognizes revenue and expenses only when the related cash is received and disbursed. Thus income and expense recognition of a transaction is dependent on cash received and disbursed. Under accrual accounting, revenue is recognized when earned and expenses are booked when incurred. Almost all companies use accrual basis of accounting these days. In the case of sole proprietary businesses, cash basis of accounting is seen in practice. Where the sole proprietary businesses are well established, they also practise accrual basis of accounting. Note: Inherent in the accrual basis of accounting, is the matching principle, which states that expenses should be deducted against revenue to which they are directly related.1.4 Book-keeping versus accounting Book-keeping is the systematic recording of a company’s financial transactions. It also includes the maintenance of correct and up-to date financial records of a company. The process is up to drawing of trial balance. There are two methods of recording the financial transactions:  Single entry It is also known as incomplete recording of transactions. Every transaction is recorded with its single aspect. Preparing complete set of financial statements is difficult from single entry record books. It is old system of book-keeping. (10/48)
  12. 12. ACCOUNTING CYCLE  Double entry It is about complete recording of transactions with its dual aspect. Every transaction has a debit and credit aspect which is recorded in two accounts separately. It is perfect system of book-keeping and is used all over the world. Complete set of financial statements can be prepared from the double entry records easily. “Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least of financial character and interpreting the results thereof.” (AICPA) Book-keeping is the part of accounting. Where the work of a book-keeper finishes, the work of an accountant starts. Accountants often review the work of the book-keepers. The spectrum of accounting activity is much broader than book-keeping.1.5 Introduction to an account An account represents a document used to record all similar transactions. It consists of a title, a debit column, and a credit column. The left side of an account is called as debit side, and the right side of the account is known as credit side. The balance of an account is determined by subtracting the smaller sum (debit or credit) from the larger sum. Initially, all transactions are recorded in a journal or day-book in a process known as journalizing. When the information recorded in the journal is transferred to the individual accounts, this process is known as posting. Total debits and credits of any transaction must always be equal. A single account is often called a T-Account because of its appearance similar to an alphabet T. When several related accounts grouped together in a register or book format, they are called a ledger. Accounts whose balance is carried forward from period to period are known as real accounts or balance sheet accounts. In a double entry accounting system, all journal entries require a debit entry in one account to be simultaneously matched by an equal credit entry in another account. A journal entry composed of more than one debit or credit is a compound journal entry.1.6 Rules for increasing & decreasing accounts The following are rules for increasing and decreasing accounts.  Asset accounts normally have debit balances and are increased by debits.  Liability accounts normally have credit balances and are increased by credits.  Owners equity accounts normally have credit balances and are increased by credits.  Revenue accounts are increased when credited.  Expense accounts are increased when debited. (11/48)
  13. 13. ACCOUNTING CYCLE1.7 Accounting equation The accounting equation is the basis of double entry book-keeping of today. The accounting equation has told us that balance sheet must always balance. It is given as follows: Assets = Owners’ Equity + Liabilities1.8 Types of accounting entries The following are the types of accounting entries that are passed in books of accounts at different times of the accounting cycle:  Recording entries: These entries are passed when any transaction takes place.  Correcting entries: These entries are passed when incorrect entries are rectified.  Adjusting entries: Normally at year end, many entries are passed to adjust balance sheet accounts.  Reversing entries: These entries are passed at year end for some deferred and accrued accounts.  Closing entries: These entries are passed at year end to closing all profit & loss accounts.1.9 Normal account balances Assets, drawing, dividends, and expense accounts normally have debit balances. Liabilities, owners equity, retained earnings, and revenue accounts normally have credit balances. There can be special circumstances where accounts will not have a normal balance, but this usually is an indication of an error or extraordinary or unusual transactions.1.10 Income statement accounts Income statement accounts or nominal accounts have a direct effect on the balance of owners equity. Expense accounts decrease owners equity, while revenue accounts increase owners equity. The net gain or loss is determined by subtracting expenses from revenues. At the end of a financial period, all expense and revenue accounts are closed to a summarizing account usually called Income Summary. For this reason, all income statement accounts are considered to be temporary or nominal.1.11 Balance sheet accounts Balance sheet accounts or permanent accounts are classified as assets, liabilities, or owners equity. Income statement accounts are classified as either expenses or revenues. Assets are divided into two categories, depending upon their expected life. Current assets are those that are usually sold or consumed within a year. Fixed assets are held for (12/48)
  14. 14. ACCOUNTING CYCLE periods longer than a year. Among fixed assets, all assets except land depreciate. Liabilities are also divided into two categories: current, for those payable within a year, and long-term, for those with maturities exceed one year. Current assets typically include cash, notes receivable, accounts receivable, inventories and prepaid expenses (such as insurance premiums). Fixed assets typically include property, plant and equipment, vehicles, investments, patents, franchises and trademarks. Both tangible and intangible items can be assets, provided they have some monetary value. Current liabilities include bank credit outstanding, accounts payable, interest payable, wages payable and taxes payable. Long term liabilities include loans beyond one year, notes and bonds issued by company.1.12 Classifying balance sheet accounts Owners equity is the portion that remains after liabilities are subtracted from assets. For a sole proprietorship or partnership, capital represents the owners equity. For a company, capital stock is the investment made by stockholders. Retained earnings represent net income that a company retains. Dividends are earnings of a company that are distributed to shareholders. Drawings represent assets taken out by owners of proprietorships or partnerships. Drawings and dividends reduce owners equity.1.13 Classifying income statement accounts Revenues increase the value of owners equity. Revenues include sales, fees earned, services, interest income and rental income. For businesses with more than one source of income, it is recommended to maintain separate accounts. Expenses vary for different businesses, and they should be classified according to the size and type of expense.1.14 Chart of accounts All accounts of a business should be listed in a chart of accounts. Usually the accounts are classified as:  Assets,(for example Asset Account number may start from 1000 to 5000)  Liabilities,(Account number from 5001 to 10000)  Owners equity,(Account number from 10001 to 15000)  Revenue, ( Account number from 15001 to 20000)and  Expenses, (Account number from 20001 to 25000). Accounts appear in the General Ledger in a sequential order of the chart of accounts. The first digit of a number in the chart of accounts indicates the major division in which the account is placed. A second number of an account represents a specific category. When the General Ledger is first prepared and account balances from the previous period are entered, this is known as opening the ledger. (13/48)
  15. 15. ACCOUNTING CYCLE1.15 The flow of data The accounting data normally follows a normal pattern of flow. Its order is:  The actual business transaction requires the preparation of documentation,  The entry for the transaction is recorded in the journal or day-book, and  The journal entry is posted to General Ledger.1.16 The two column journal Of all types of journals, the two column journal is the simplest to use. It has a debit column and a credit column used for recording all initial transactions. Before a transaction is entered into a journal, it is necessary to determine the following:  Which accounts will be affected,  Whether the affected account increases or decreases, and  Whether the transaction should be recorded as a debit or credit.  An explanation of the transaction is desirable. When journalizing entries it is customary to enter the account numbers and exact name of the accounts to be debited and credited, to write in the debit portion first above the credit portion, and to indent slightly the credit entry. The complete date of a transaction must always appear. Most often expense account will have only debit entries; revenue accounts only credit entries, while balance sheet accounts may have either.1.17 Three-column & four-column accounts Three-column and four-column accounts are often used instead of two-column accounts. The purpose of the additional columns is to keep running balances of both debits and credits in the four-column account, or a net of the two in the three-column account. All accounts, as well as most accounting forms used to record transactions, often have a posting reference column. In the journal, the posting reference column is used to record the account number or code. In the individual account, the posting reference (also called journal reference) is used to record the page number of the journal where the entry was made. Three-column and four-column accounts must show their account number and name, year and month, at the top of each page. Three-column and four-column accounts are most conveniently used in computer based accounting since debit and credit balances are automatically calculated. (14/48)
  16. 16. ACCOUNTING CYCLE1.18 The trial balance & errors The trial balance is a list of accounts with their debit or credit balances. It is usually prepared at the end of an accounting period. The advantages of using a trial balance are:  It reveals mathematical errors since total debits must equal total credits, and  It assists in the preparation of financial statements. It should be noted, however, that trial balances cannot detect every type of error. The first step in preparing a trial balance is to calculate the balance of each of the accounts in the General Ledger. Some of the errors that the trial balance will not reveal are for instance:  Journalizing a transaction twice,  Forgetting to record a transaction,  Entering an erroneous but identical amount in debit and credit,  Posting part of a transaction as a debit or credit to the wrong account Errors that cause the trial balance not to balance are  The beginning amount of an account was incorrectly recorded,  A debit entry was posted as a credit entry,  A debit or credit balance was omitted,  A digit in a number was moved one or more spaces (known as slide). Determining the amount of the difference between debit and credit can help to look for such amount. For instance, when a debit and a credit were interchanged, the trial balance difference will be twice this amount. A major function of an auditor is to find accounting errors.1.19 Matching revenues & expenses There are two methods of recording revenues and expenses in the income statement: accrual basis and cash basis. The accrual basis of accounting is a more precise method of matching revenues and expenses, and it is more widely used. It matches revenues and expenses when they are incurred rather than when cash is received or disbursed. The cash basis of accounting records revenues and expenses only when cash is received or disbursed, and this method is often not acceptable for many forms of business. The cash basis of accounting does not match revenue with the expenses, whereas accrual basis of accounting matches revenues with expenses therefore reflects correct profitability of business for the given period of time. (15/48)
  17. 17. ACCOUNTING CYCLE1.20 The adjustment process At the end of a financial period, many balances listed in the trial balance are in need of some adjustment. Common adjustments pertain to prepaid expenses, fixed assets, and accrued expenses. If the proper adjusting entries are not made, financial statements will be incorrect. It is not necessary to keep track of transactions that affect revenues and expenses on a day to day basis. Adjustments should be made at the end of each accounting period.1.21 Prepaid expenses - adjustments At the end of an accounting period, adjustments must be made to reflect the portion of the asset that has been consumed during the period. The amount of asset or prepaid expense consumed is recorded as a debit to the expense account, and a credit to the asset account. Should an adjusting entry not be made, expenses, net income, owners equity and assets would all be overstated.1.22 Non-current assets - adjustments Non-current assets comprise of tangible and intangible assets owned by a company. Although it is often not visible, the usefulness of non-current assets declines over the period of use. This loss of usefulness is known as depreciation or amortization, and it requires an adjusting entry periodically. The decline in value requires a debit to depreciation or amortization expense account, and a credit to accumulated depreciation or amortization (which is said to be a contra asset account). The difference between the balances of the asset and contra asset accounts is the book value of the asset. If the adjusting entry is not made, assets, owners equity, and net income will be overstated, and expenses will be understated.1.23 Liabilities - adjustments While most expenses are prepaid, a few are paid after a service has been performed. This is the case of wages and salaries. Since the expense has not been paid but services have been received, an accrued expense and a liability have taken place. The adjusting entry requires a debit to an expense account and a credit to a liability account. Failure to do so will result in net income and owners equity being overstated, and expenses and liabilities being understated.1.24 Work sheets & financial statements The work sheet is a collection of important data that is used to determine which adjusting entries must be performed. It also assists in the preparation of financial statements. The first step of preparing a work sheet is the trial balance. Once a trial balance proves (i.e. total debits equal total credits), adjusting entries can be performed. To make certain all debits and credits still prove after all adjusting entries, an adjusted trial balance is created. (16/48)
  18. 18. ACCOUNTING CYCLE Once the adjusted trial balance proves, if is separated into an income statement and a balance sheet. All columns of the work sheet should have equal balances for debits and credits.1.25 Preparing financial statements The work sheet is used in the preparation of the financial statements. The results of the income statement (net profit or loss) are transferred to the statement of owners equity. If additional funds have been invested or withdrawn over the period, such changes are recorded to the statement of owners equity. The owners equity account in the balance sheet is transferred from the statement of owners equity. All other balances of the balance sheet are transferred from the work sheet balance sheet columns.1.26 Journalizing & posting closing entries After the financial statements are completed, all adjusting entries are recorded in the journal and posted to the ledger so that all financial statements are in agreement. It is necessary to close all temporary accounts and record the net change to the owners equity account. This is accomplished by journalizing and posting closing entries for all temporary accounts. An Income Summary account is used to summarize revenue and expense accounts, and establishing the net profit or loss for the period. In addition, any transaction that increases or decreases capital should also be posted to the appropriate capital account. PROCEDURES TO CLOSE TEMPORARY ACCOUNTS  Debit all revenue accounts, and credit Income Summary.  Credit all expense accounts, and debit Income Summary.  Add debit and credit columns of Income Summary. If the credit balance exceeds the debit balance, a profit has been realized.  Results of the Income Summary should be posted to a capital account (Owners or Shareholders equity).  If there is activity in the Drawing or Dividend accounts, it is necessary to credit those accounts and debit a capital account.1.27 The accounting cycle The accounting cycle begins with the analysis of all transactions and recording them in the journal. Once all transactions have been recorded in the journal, they are posted to the ledger and a trial balance is drawn. The trial balance, adjusting entries, and any additional information for the financial statements are recorded in the work sheet. After the completion of the work sheet, the financial statements are finalized. All adjusting and (17/48)
  19. 19. ACCOUNTING CYCLE closing entries are then journalized and posted to the ledger. To ensure all entries were correctly made, a post-closing trial balance is prepared to show the equality of debits and credits, as well to confirm Assets, Liabilities, and Capital accounts with proper open balance. The accounting cycle finishes with the passing of reversing entries wherever needed.1.28 The final product of book-keeping and accounting The following statements are the final product of book-keeping and accounting cycle.  Statement of financial position.  Statement of comprehensive income or statement of earnings.  Statement of cash flows.  Statement of changes in stock-holders’ or owners’ equity. Important note IFRSs have used the following terms for the old terms: # Old term New adoption 1 Balance Sheet Statement of financial position 2 Profit & Loss Account Statement of earnings 3 Cash Flow Statement Statement of cash flows 4 Retained Earnings Statement Statement of changes in owners’ equity (18/48)
  20. 20. ACCOUNTING CYCLE UNIT 2: ACCRUALS & DEFERRALS2.1 Introduction Deferrals and accruals are instrumental in properly matching revenues and expenses. A deferral delays the recognition of either an expense that has been paid or revenue that has been collected. An accrual is an expense that has not been paid or revenue that has not yet been received.2.2 Deferrals - prepaid expenses Prepaid expenses represent the cost of goods and services purchased that are not entirely used up at the end of the year. Adjusting entries are necessary so that asset and expense accounts have the proper balances. Prepaid expenses can be initially recorded as either an asset or an expense. Either method will yield the same results, but adjusting entries to obtain the final result differ. The advantage of recording a prepaid expense initially as an asset is that no reversing entry is necessary.  When a prepaid expense (rent, insurance, etc., etc.) is recorded as asset, following set of entries is passed: Date Description Ref. Dr. Cr. AED. AED. 01/01/11 Prepaid rent expense xxx Cash xxx (Being Cash Paid as prepaid expense.) 31/12/11 Rent expense xxx Prepaid rent expense xxx (Being adjustment of prepaid rent passed for the amount of expense for the year 2011) N.B.: There is no need to pass reversing entry in this case. Closing entry is the same that is passed for all expenses. (19/48)
  21. 21. ACCOUNTING CYCLE  When a prepaid expense is recorded as expense initially, following set of entries is passed: Date Description Ref. Dr. Cr. AED. AED. 01/01/11 Rent expense xxx Cash xxx (Being Cash Paid as prepaid expense.) 31/12/11 Prepaid expense xxx Rent expense xxx (Being adjustment of prepaid rent passed for the amount of unutilized or remaining balance of prepaid expense after the expense for the year 2011) 01/01/12 Rent expense xxx Prepaid rent xxx (Reversing entry of adjusting entry passed on 31/12/11.) N.B.: Closing entry is the same as passed in above illustration.2.3 Deferrals - unearned revenues When revenue is received before goods are delivered or services performed, the revenue is said to be unearned. Unearned revenues can initially be recorded as either a liability or revenue. When unearned revenues are recorded as liabilities, an unearned revenue account is credited. An advantage of this method is that no reversing entry is necessary. When unearned income is recorded as revenue, a revenue account is credited. This method requires a reversing entry at the beginning of the new period. Both methods produce, however, the same end result. (20/48)
  22. 22. ACCOUNTING CYCLE When advance receipt of revenue is recorded as unearned revenue, following set of entries shall be passed: Date Description Ref. Dr. Cr. AED. AED. 01/01/11 Cash xxx Unearned revenue xxx (Being Cash received for revenue not earned.) 31/12/11 Unearned revenue xxx Revenue earned xxx (Being adjustment of advance receipt of revenue passed for the amount of revenue earned for the year 2011) N.B.: There is no need to pass reversing entry in this case. Closing entry is the same that is passed for revenue.  When advance receipt of revenue is booked as revenue earned, following set of entries is passed: Date Description Ref. Dr. Cr. AED. AED. 01/01/11 Cash xxx Revenue xxx (Being cash received for revenue not earned.) 31/12/11 Revenue xxx Unearned revenue xxx (Being adjustment of advance receipt of revenue passed for the amount of revenue unearned on 31/12/11) 01/01/12 Unearned revenue xxx Revenue xxx (Being reversing entry of adjusting entry passed on 31/12/11) N.B.: Closing entry is the same that is passed for revenue. (21/48)
  23. 23. ACCOUNTING CYCLE2.4 Accruals - liabilities or expenses Many expenses which accumulate on a daily basis are only recorded at set intervals. At the end of an accounting period a portion of such expenses (for instance, salaries) often remains unpaid. Such accruals are considered to be both liabilities and expenses. An adjusting entry is necessary at the end of an accounting period to properly reflect the portion of the accrued but yet unpaid expense and liability. At the start of the next period, the adjusting entry is reversed to simplify accounting. Date Description Ref. Dr. Cr. AED. AED. 31/12/11 Salaries expense xxx Accrued salaries expense xxx (Being salaries accrued on the closing of the year 31/12/11.) 01/01/12 Accrued salaried xxx Salaries expense xxx (Being reversing entry of the adjusting entry passed on 31/12/11.)2.5 Accruals - assets or revenues Many businesses only record revenues when they are actually received. At the end of an accounting period, all revenues earned but not yet collected require adjusting entries. The adjustment is performed by debiting an asset account and crediting a revenue account. As a result, financial statements will be able to properly match revenues and expenses. A reversing entry is performed at the first day of the new period to simplify accounting. Date Description Ref. Dr. Cr. AED. AED. 31/12/11 Accrued Revenue xxx Revenue xxx (Being the amount of revenue earned but not collected on 31/12/11) 01/01/12 Revenue xxx Accrued Revenue xxx (Being the reversing entry of the adjusting entry passed on 31/12/11.) (22/48)
  24. 24. ACCOUNTING CYCLE2.6 Reviewing accruals and deferrals Although all accruals and deferrals require adjusting entries at the end of an accounting period, reversing entries are not necessary for all adjustments. Reversing entries should only be performed under the following circumstances:  When an accrued asset or an accrued liability is adjusted,  When a prepaid expense is initially recorded as an expense,  When unearned revenue is initially recorded as revenue. (23/48)
  25. 25. ACCOUNTING CYCLE UNIT 3: ACCOUNTING SYSTEMS3.1 Principles of accounting systems The accounting system of an organization should provide all necessary information. The type of accounting system used depends on the information needs of an organization. All accounting systems should have the following characteristics:  Cost effectiveness,  Adequate internal controls,  Flexibility to a changing environment, and  Compatibility and adaptability to an organizations structure. Accounting system is an organized set of manual and computerized accounting methods, procedures and controls established together to record, classify, analyze, summarize, interpret and present accurate and timely data for managerial decisions. The accounting system can be manual or mechanical. In the past, the accounting systems were maintained manually. Even today, many small businesses use manual accounting systems. Manual accounting systems have many limitations for accuracy and reporting. Therefore, companies use computerized accounting systems. They provide fast and accurate reporting of the company’s earnings and financial health at any time. Some of the famous accounting system providers are:  SAP  Oracle  Microsoft3.2 Installing & revising accounting systems The installation and revision of an accounting system requires a complete knowledge of business operations. The following steps are necessary when installing or changing an accounting system.  Systems analysis This stage determines data needs, the sources of data and any problem in processing current data.  Systems design This stage involves designing new or revising current accounting systems based upon the results of the system’s analysis. (24/48)
  26. 26. ACCOUNTING CYCLE  Systems implementation This final stage installs and evaluates the new or revised accounting system.3.3 Internal controls Internal controls are designed to safeguard assets, check accuracy of accounting data, promote efficiency, and encourage adherence to company policies. Internal accounting controls are specifically concerned with the protection of assets and the reliability of accounting information. Internal administrative controls are concerned with operational efficiency, and help determine whether business goals are being met.3.4 General Ledger A General Ledger is a complete record of financial transactions over the entire life of a company. The ledger holds account information that is needed to prepare financial statements. Trial balance is drawn from the closing balances of accounts given in a General Ledger. A General Ledger has the following set of accounts:  Assets  Liabilities  Revenue  Expenses  Gains  Losses  Owners equity3.5 Subsidiary Ledgers Subsidiary Ledgers are used for accounts that have a large number of individual accounts with common characteristics. Subsidiary Ledgers are commonly used for accounts receivable and accounts payable; both consist of a large number of smaller accounts. The General Ledger contains all balance sheet and income statement accounts. Every Subsidiary Ledger has a controlling account which can be found in the General Ledger. The sum of the balances of the Subsidiary Ledger must be equal to the controlling account.3.6 Difference between General Ledger & Subsidiary Ledger The difference between subsidiary and General Ledger accounts is functional. A companys General Ledger is the book of top-tier accounts that make up its accounting system. The Subsidiary Ledger is a sub-account of a General Ledger account. General (25/48)
  27. 27. ACCOUNTING CYCLE Ledgers record line item transactions in major account categories. Subsidiary Ledgers provide the details for one of those line items, creating a separate mini account for the item that can track transactions that are specific to that one item. For example, trade debtors’ account in a General Ledger has a balance of 100 customers over a given period of time whereas a Subsidiary Ledger has the detailed accounts of 100 customers. A reconciliation of the General Ledger Balance with Subsidiary Ledger Balances is recommended where manual accounting systems are in place.3.7 Special Journals Special journals (or day books) are designed to record a specific type of transaction which occurs frequently. The following is a summary of the four most commonly used special journals:  Purchases Journal: used to record purchases on credit,  Sales Journal: used to record all sales made on credit,  Cash Payments Journal: records all cash disbursements, and  Cash Receipts Journal: records all cash receipts. In certain instances, business documents such as purchases and sales invoices are used instead of special journals to reduce expenses.3.8 Purchases Journal Items commonly purchased on account are goods held in inventory for sale, supplies, and equipment. The accounts payable account is always credited, and an asset account is debited. Assets purchased on a recurring basis have their own column in the journal. Assets purchased less regularly are posted in the sundry accounts section of the journal. At all times, total debits must equal total credits. At the end of an accounting period, all entries should be posted to a Subsidiary Ledger or a General Ledger.3.9 Cash Payments Journal When the Cash Payments Journal is used, the cash column is always credited whenever a payment is issued. When a payment is made for goods previously purchased on credit, the accounts payable column is credited. In the event a discount is offered for early payment, the purchases discounts column should be debited. The sundry accounts column is used for debits to accounts which do not have an individual column. At the end of the month, all data from the journal should be posted to Subsidiary Ledgers or the General Ledger. The sum of the accounts payable Subsidiary Ledger must be equal to the controlling account. In the event it is not, errors must be found and corrected. (26/48)
  28. 28. ACCOUNTING CYCLE3.10 Sales Journal The Sales Journal is only used to record sales of merchandise on account. A unique feature of the Sales Journal is that accounts receivable debits and credits share the same column. A column also often exists to record sales tax payable. Any sales returns or allowances granted for goods sold on credit require an entry to the general journal. If a cash refund is given, the transaction should be recorded to the Cash Payments Journal.3.11 Cash Receipts Journal The Cash Receipts Journal is used to record all transactions that increase the cash balance. The most common sources of cash receipts are cash sales and payments for goods on account. When debtors pay for goods purchased on account, the accounts receivable column should be credited. If a cash discount is taken by a customer, the sales discount column should be debited for the cash discount. All accounts in the Cash Receipts Journal are posted periodically to the General Ledger. Accounts receivables should be posted monthly to the accounts receivable Subsidiary Ledger.3.12 The voucher system One of the most common methods to control transactions is the voucher system. The components of a voucher system are  Vouchers: documents proof of a transaction,  A voucher register: to record every voucher,  An unpaid voucher file,  A paid voucher file, and the  A check register: to record the payment of each voucher. The voucher system provides effective accounting controls and helps management in effective internal control process.3.13 Types of vouchers Following are the types of vouchers that are used in every business:  Cash Receipt Voucher (CRV)  Cash Payment Voucher (CPV)  Bank Receipt Voucher (BRV)  Bank Payment Voucher (BPV)  Journal Voucher (JV) is prepared for all non-cash transactions. (27/48)
  29. 29. ACCOUNTING CYCLE Important note These are the minimum number of vouchers that are required in an accounting system. If we examine the computerized accounting systems, they have opened a large number of vouchers depending upon the company needs. For instance, there can be many vouchers that are automatically generated by the system to adjust various accounts at the close of the year and they fall under different names but they have common nature to that of a Journal Voucher (JV). A computerized system may use any number of vouchers but if we see the nature of all vouchers they are falling the five main categories mentioned above.3.14 Important facts about vouchers  Printed vouchers must be used.  All vouchers must be pre-numbered.  All vouchers must be properly completed for all particulars.  All vouchers must be signed by all concerned officials.  All vouchers must be supported with all documentary evidences of each transaction. Voucher is the proof that the transaction has happened. This is why; a separate voucher is prepared for each transaction. This is highly incorrect practice to prepare one voucher for a number of transactions.  All vouchers must be filed properly.  Cancelled vouchers must have a separate record for their verification by the auditors.  An example for signing a cash or Bank Payment Voucher, following procedures must be completed. Check that the receiving report, invoice and purchase order is attached with it. Perform necessary calculations for possible discounts availed on the purchase transaction.3.15 Facts about a Voucher Register  All vouchers must be recorded in the voucher register.  Vouchers are listed in numerical order.  The register records the payee, the date the payment is made and the number of the check issued for payment,  The Accounts Payable account is always credited, but there may be different accounts to be debited.  The Sundry Accounts is used to debit accounts not listed in the other Register columns.3.16 Voucher files procedures  Unpaid vouchers are filed in the unpaid voucher file.  Unpaid vouchers should be filed in the order they are due. (28/48)
  30. 30. ACCOUNTING CYCLE  Paid vouchers are filed in the paid voucher file.  Paid vouchers are filed in numerical order.3.17 Using a Check Register  When a voucher is paid, it is recorded in the check register.  The check register is similar to the Cash Payments Journal.  All checks should be listed numerically, even those that are voided.  Cash in Bank account should always be credited. If a discount is taken, credit the Purchases Discount account.  Voucher numbers and a running cash balance column are used in the check register.3.18 Year end Every company is supposed to close the books of accounts at its year end. The year-end may or may not be a calendar year. It depends upon the choice of the management or the cycle of the business to choose a year end. For example, in textile industry, the year-end is according to the cotton crop seasons. And in Banking Industry the year end is different from textile industry based on the banking traditions profession-wide. At each year-end, record books are closed to evaluate the following:  Profitability of the business for the year  Financial health of the business at the end of the year ( increase or  decrease in assets and liabilities accounts)  Cash flow position during the year for the year (separate for each set of operating, investing and financing activities of the business during the year.)  Increase or decrease in the wealth of the owners of the business for the year. (29/48)
  31. 31. ACCOUNTING CYCLE UNIT 4: CASH& BANK4.1 Bank accounts The most effective tool used to control cash is a bank account. It provides a double record of all cash transactions. In order to provide effective controls on the use of bank accounts, special documents are used to evidence transactions. Signature cards are used by all employees authorized to make withdrawals. Deposit slips must accompany deposits, and checks must be issued for all payments. A remittance advice is sent with each payment to ensure that proper credit is recorded by creditors.4.2 Bank statements An advantage of using a bank account to control cash is that banks show a bank statement online that reflects all the transactions in the account on real time basis. Information normally present in the bank statement consists of the beginning and ending balances, deposits, other credits, withdrawals and other debits. The cancelled checks are enclosed with the statement, as well as debit and credit memorandums (for items processed by the bank usually unknown to the depositor). Rarely will the bank statement balance and the depositors Cash in Bank account balance be exactly the same, and they must be reconciled.4.3 Bank reconciliations Bank reconciliation is a method used to determine the reasons for discrepancies between the bank statement balance and the Cash in Bank account balance and to calculate an adjusted balance. Discrepancies are usually due to outstanding items which have not yet been recorded by either of the bank or the company, and which typically include checks not yet presented for collection, deposits in transit and bank service charges. Errors are another common cause of discrepancies, which the reconciliation will help correct. Finally, the reconciliation may uncover irregularities.4.4 Bank reconciliations statements Bank reconciliation is divided into two sections, the balance per bank statement and the balance per depositors records. Although it is possible to reconcile one balance to the other, common practice adjusts both balances to prove to one another. Outstanding transactions unknown to the depositor discovered when the bank statement was sent require journal entries. Since bank statements are available online, therefore, bank reconciliation statements can be prepared on daily basis. It provides real time controls on discrepancies in bank statements and bank accounts. In companies where bank transactions are in thousands in number in a day or greater than this, there are chances of very big discrepancies in (30/48)
  32. 32. ACCOUNTING CYCLE accounts. To avoid the risk of unrecorded transactions, the accountants must prepare bank reconciliation statement of all bank accounts on daily basis before the close of every day. XYZ LLC Bank Reconciliation Statement For the Month of December 31, 2009 Balances as per Bank Statement xxx Reconciling Items: Less: Co. Credits not debited by bank (xxx) Plus: Co. Debits not credited by bank xxx = Balance as per company books xxxx4.5 Cash accounts There are often several cash accounts because they serve different purposes. The Cash in Bank account represents the checking account that processes deposits, checks and memorandum items. The Cash Short and Over account is used to record any variance by sales clerks. The Cash on Hand Fund is used to provide change to conduct business with customers. The Petty Cash Fund is used to pay for small items with cash. Each of these cash accounts needs to be strictly controlled to prevent mishandling.4.6 Internal controls for cash accounts Numerous procedures are available to control cash accounts. Monthly bank statements help verify the cash account balance. The bank reconciliation is particularly useful in controlling cash receipts. The voucher system is used to control cash payments. Different cash funds exist for specific purposes to keep track of each type of cash transaction. It should be noted that it is of utmost importance to separate cash handling and cash related accounting duties.4.7 Electronic funds transfer The evolution of electronic funds transfer (EFT) has changed the way cash transactions are processed. EFT uses electronic impulses that are computerized to perform cash transactions. This eliminates the need for checks and physical money. EFT has a particularly strong presence in retail sales. Point-of-sale systems are used by customers to pay for purchases using credit cards, charge cards, and bank cards. The greatest benefit EFT can provide is reduced costs, and quicker and more accurate information. (31/48)
  33. 33. ACCOUNTING CYCLE UNIT 5: RECEIVABLES5.1 Introduction Receivables are monetary claims against trade debtors for sales made on credit to customers. Credit can be granted in two forms: open account or evidenced by a formal instrument. When a formal instrument of credit that is a promissory note, the creditor has a stronger legal claim and can endorse it to a third party. The party that promises payment is known as the maker, and the party entitled to receive the payment is the payee. Notes receivable can be interest or non-interest bearing. The amount due at maturity, known as maturity value, is equal to the face value plus any accrued interest. Receivables not expected to be collected within the current year, should be listed as investments on the balance sheet.5.2 Receivable controls Receivables require the same internal controls as other assets of a business. Employees responsible for collecting and approving receivables should not be involved with accounting aspect related to them. All accounting functions should be designed so that the work of one employee can be used as verification of another employees work. A business that has a substantial amount of notes may find the use of a notes receivable register very helpful. It provides detailed information on each note, and assists in the timely collection of notes. Proper controls of receivables also include obtaining approval for credit sales, sales returns and allowances, and sales discounts.5.3 Calculating interest Interest rates are usually stated on an annual basis. The interest is computed by multiplying principal by rate and then by time (principal x rate x time). The maturity value is determined by calculating interest and adding it to the face value of the note. When interest is computed for periods of less than a year, time is expressed as a fraction. The numerator of the fraction is the length of the note and the denominator is the number of days in a year. Government agencies use 365 days in the denominator, while the private sector uses 360 days.5.4 Accounting for notes receivable When a note is received from the debtor (i.e. open account customer), a journal entry should be made debiting Notes Receivable and crediting Accounts Receivable account. Notes receivable that do not mature by the end of a fiscal period, require both adjusting and reversing entries for the accrued interest. This is done so that interest income is allocated to the proper financial periods. When a note matures and is paid, the Cash account is debited and the Notes Receivable and Interest Income accounts are credited. (32/48)
  34. 34. ACCOUNTING CYCLE5.5 Discounting a note receivable In the event a business is in need of cash, it has the option to transfer its notes receivable to a bank, which is known as discounting. The interest a bank charges on the period it holds a note is known as discount. Depending upon the arrangement with the bank, the company may still be liable in the event a debtor defaults on the payment. It is necessary to disclose these contingent obligations on a firms Balance Sheet in a foot note. When proceeds are received for the discounted notes, the Cash account is debited, and the Notes Receivable account credited. If the proceeds exceed the face value of the note, the Interest Income account is credited. If the proceeds are less than the face value of the note, Interest Expense is debited.5.6 Dishonored notes receivable When the maker of a note fails to pay on the due date, the note receivable is considered to be dishonored. A dishonored note is no longer negotiable. In the books of creditors, the following entry is made: Dr. Accounts Receivable Cr. Notes Receivable Cr. Interest Income or Interest Receivable When a note previously discounted with a bank is dishonored, the holder of the note (the bank) notifies the endorser (i.e. the company) of non-payment. Protest fees are charged to the endorser for legal fees.5.7 Receivable balances which become uncollectible No matter what kind of credit policy or collection procedures a business establishes, a certain percentage of receivables will usually turn out to be uncollectible. When a receivable is determined to be uncollectible, it is written-off as an operating expense. Strong indications that a receivable may be uncollectible are the declaration of bankruptcy by the debtor, repeated failures to collect, disappearance of the debtor, and debts that are beyond the statute of limitations. Two methods exist to write-off receivables. The direct write-off method records the expense when the receivable is uncollectible, while the allowance method makes a provision for a portion of the current year sales to become uncollectible throughout the entire year.5.8 Methods used to estimate uncollectible balances There are several methods of estimating uncollectible. The most commonly used methods base their estimates on sales data or the age of the receivables. Estimates based on sales figures can be determined by taking a percentage of either total sales or credit sales. An estimate of uncollectible based on an analysis of receivables, classifies accounts into outstanding age groups. The longer a receivable is past due, the higher the probability of (33/48)
  35. 35. ACCOUNTING CYCLE nonpayment. If the estimate is larger than the balance of the Allowance for Doubtful Accounts, the excess should be debited to the Uncollectible Accounts Expense and credited to the Allowance for Doubtful Accounts.5.9 The allowance method The allowance method of accounting for uncollectible estimates the percentage of accounts that will be uncollectible. Once the amount is determined, an adjusting entry is made that debits the Uncollectible Accounts Expense and credits the Allowance for Doubtful Accounts (also known as Allowance for Bad Debt). When a specific account is determined to be uncollectible, the Allowance for Doubtful Accounts is debited and the Accounts Receivable account is credited. The advantage of using the allowance method is it provides a reduction of the value of receivables and recognition of expense in the period the corresponding sales have taken place.5.10 The direct write-off method The direct write-off method only records an uncollectible account expense when an account has been determined to be uncollectible. This method is not recommended because the recognition of the expense does always occur in the year the corresponding revenues were recorded. It has, however, the advantage of simplicity since no adjusting entry is necessary at the end of a financial period. The method is best used by businesses that do not have a large number of credit sales. In the event an account needs to be reinstated, the Accounts Receivable account is debited. Uncollectible Accounts Expense should be credited. (34/48)
  36. 36. ACCOUNTING CYCLE UNIT 6: INVENTORIES6.1 Inventory & financial statements Inventories are usually the largest current asset of a business and proper measurement of them is necessary to assure accurate financial statements. If inventory is not properly measured, expenses and revenues cannot be properly matched. When ending inventory is incorrect, the following balances of the balance sheet will also be incorrect as a result: merchandise inventory, total assets, and owners equity. When ending inventory is incorrect, the cost of merchandise sold and net income will also be incorrect on the income statement.6.2 Inventory accounting systems The two most widely used inventory accounting systems are the periodic and the perpetual. The perpetual inventory system requires accounting records to show the amount of inventory on hand at all times. It maintains a separate account in the Subsidiary Ledger for each good in stock, and the account is updated each time a quantity is added or taken out. In the periodic inventory system, sales are recorded as they occur but the inventory is not updated. A physical inventory must be taken at the end of the year to determine the cost of goods sold. Regardless of what inventory accounting system is used, it is good practice to perform a physical inventory at least once a year.6.3 Determining inventory quantities & costs All goods owned by a business (whether or not physically present on the business premises), are included in inventory when an inventory is taken. This requires that all shipping documents be examined, and all merchandise out on consignment be identified. Determining the quantity of goods on hand should be performed by at least two individuals, and a third should verify accuracy of the count (especially if the goods have a high monetary value). When determining the cost of goods, all expenses incurred to acquire them are included in the purchase price.6.4 Inventory costing methods - periodic The periodic system records only revenue each time a sale is made. In order to determine the cost of goods sold, a physical inventory must be taken. The most commonly used inventory costing methods under a periodic system are  First-in first-out (FIFO),  Last-in first-out (LIFO), and  Average cost or weighted average cost. (35/48)
  37. 37. ACCOUNTING CYCLE These methods produce different results because their flow of costs is based upon different assumptions. The FIFO method bases its cost flow on the chronological order purchases are made, while the LIFO method bases it cost flow in a reverse chronological order. The average cost method produces a cost flow based on a weighted average of unit costs.6.5 Comparing inventory costing methods The choice of inventory costing method affects the balances of:  Ending inventory,  Cost of goods sold, and  Gross and net profit. During periods of rising prices, the FIFO method generally produces a larger ending inventory, a smaller cost of goods sold and a higher profit. During periods of rising prices, the LIFO method produces a smaller ending inventory, a larger cost of goods sold and a smaller profit. During periods of declining prices the effects of the two methods are reversed. The average cost method produces results that are in between the LIFO and FIFO methods.6.6 Using non-cost methods to value inventory Under certain circumstances, valuation of inventory based on cost is impractical. If the price of a good drops below the purchase price, the lower of cost or market method of valuation is recommended. This method allows declines in inventory value to be offset against income of the period. When goods are damaged or obsolete, and can only be sold for below purchase prices, they should be recorded at net realizable value. The net realizable value is the estimated selling price less any expense incurred to dispose of the good.6.7 Periodic versus perpetual inventory systems There are fundamental differences for accounting and reporting merchandise inventory transactions under the periodic and perpetual inventory systems. To record purchases, the periodic system debits the Purchases account while the perpetual system debits the Merchandise Inventory account. To record sales, the perpetual system requires an extra entry to debit the Cost of goods sold and credit Merchandise Inventory. By recording the cost of goods sold for each sale, the perpetual inventory system alleviated the need for adjusting entries and calculation of the goods sold at the end of a financial period, both of which the periodic inventory system requires. (36/48)
  38. 38. ACCOUNTING CYCLE6.8 Inventory costing methods - perpetual The perpetual inventory system requires that a separate inventory ledger be maintained for each good. Inventory ledgers provide detailed information on purchases, cost of goods sold, and inventory on hand. Each column gives information on quantity, unit cost, and total cost. When the average cost method is used, an average unit cost of each good is calculated each time a purchase is made. The advantages of the perpetual inventory system are a high degree of control, it aids in the management of proper inventory levels, and physical inventories can be easily compared. Whenever a shortage (i.e. a missing or stolen good) is discovered, the Inventory Shortages account should be debited.6.9 Methods used to estimate inventory cost In certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost. Two very popular methods are:  Retail inventory method, and  Gross profit (or gross margin) method. The retail inventory method uses a cost to retail price ratio. The physical inventory is valued at retail, and it is multiplied by the cost ratio (or percentage) to determine the estimated cost of the ending inventory. The gross profit method uses the previous year’s average gross profit margin (i.e. sales minus cost of goods sold divided by sales). Current year gross profit is estimated by multiplying current year sales by that gross profit margin, the current year cost of goods sold is estimated by subtracting the gross profit from sales, and the ending inventory is estimated by adding cost of goods sold to goods available for sale.6.10 IAS 2 application IAS 2 provides complete guidance for recording the cost of inventories and their subsequent disclosure in the financial statements. The inventories are valued against their Net Realizable Value (NRV) on the reporting date. Inventories are required to be stated at the lower of cost and NRV on the reporting date. (IAS 2.9) (37/48)
  39. 39. ACCOUNTING CYCLE UNIT 7: NON-CURRENTASSETS7.1 Introduction Non-current assets are assets that are held for a period exceeding one year and are used in business operations. Non-current assets are classified as tangible and intangible. Tangible non-current assets include land, buildings, equipment, furniture, plant, machinery and vehicles whereas intangible non-current assets include copy rights, goodwill, licenses, franchises, trademarks, etc. When a tangible non-current asset is initially acquired, all costs incurred for acquisition and installation are debited to that particular asset account. Expenditures that are related to land can be debited to Land, Land Improvements, or Buildings depending upon how permanent they are and how long they are expected to last.7.2 Depreciation All non-current tangible assets, except land, depreciate over the time during which they are used. Factors that contribute to depreciation are physical and functional. Physical depreciation arises from the actual use of an asset. Functional depreciation is due to obsolescence factors such as technological advances and less demand for a product. The purpose of recording depreciation is to show the decline of usefulness of an asset, not a decline in its market value. Depreciation merely reduces the value of fixed asset accounts; it does not reduce the cash account or affect cash flows.7.3 Determining depreciation Factors that determine depreciation expense are the initial cost, the residual value and the useful life. Depreciation can only be estimated because it depends on several potentially changing elements. Residual value is any value that remains after an asset has been retired. The calculation of depreciation is based on the initial cost minus residual value. Several methods used to calculate depreciation. The straight-line method is the most popular. Different depreciation methods can be used for financial statement information and tax purposes.7.4 Straight-line method The straight-line method of depreciation charges equal amounts of depreciation to each period over the useful life of the asset. It is determined by subtracting the residual value from the initial cost and dividing it by the number of the years of estimated life. Due to its simplicity, it is the most widely used method. (38/48)
  40. 40. ACCOUNTING CYCLE7.5 Units-of-production method The units-of-production method determines depreciation expense based on the amount the asset is used. The length of life of an asset is expressed in a form of productive capacity. The initial cost less any residual value is divided by productive capacity to determine a rate of unit-of-production depreciation per units of usage. Units of usage can be expressed in units of goods produced, hours used, number of cuttings, miles driven or tons hauled, for instance. The depreciation expense of a period is determined by multiplying usage by a fixed unit-of-production rate of usage. This depreciation method is commonly used when asset usage varies from year-to-year.7.6 Declining-balance method The declining-balance (a variation of this method is also known as double-declining- balance) method is a popular form of accelerated depreciating. This method does not consider the estimated salvage value in determining the depreciation rate or in computing the periodic depreciation. However, an asset cannot be depreciated beyond the estimated salvage value. Depreciation expense is highest in the first year, and becomes smaller each subsequent year.7.7 Sum-of-the-years-digits method The sum-of-the-years-digits method is a form of accelerated depreciation. The annual depreciation is calculated by subtracting salvage value from original cost, and multiplying this figure by a fractional rate of depreciation. The denominator of the fraction is the sum of the years of useful life; for a life of 4 years, the denominator is = 1 + 2 + 3 + 4 = 10. The numerator is the year in reverse order. For the first year, the numerator is 4 and the fraction is 4/10. 7.8 Composite-rate depreciation method The composite-rate depreciation method determines depreciation of a group of similar plant assets by using a single rate. This rate is determined by dividing annual depreciation by the total original cost of assets. Although specific equipment in the group may be added and retired, this method assumes that the mix will remain unchanged. Gains and losses from the retirement or disposal of assets are not realized.7.9 Comparing depreciation methods Different depreciation methods produce different results, and in some circumstances the use of a particular depreciation method is recommended. When the use of an asset fluctuates from period to period, the units-of-production method is recommended. For assets that decline in usefulness early, and are subject to high maintenance costs as they (39/48)
  41. 41. ACCOUNTING CYCLE age or used, a form of accelerated depreciation should be used, i.e. declining-balance and the sum-of-the-years- digits methods.7.10 Depreciation & income taxes Tax department may not agree with the method of depreciation used by a taxable business entity. Therefore, when a company files returns with them for the payment of tax liability for a given period of time, the depreciation is calculated again in the manner as prescribed in the tax law. Every country has its own tax law, therefore, the treatment of depreciation is also different in every country.7.11 Revising depreciation estimates Because depreciation is estimated, it often needs to be revised periodically over the life of the asset. An error in estimating the salvage value, the years of useful life, or both can require a revision. Previously recorded depreciation is not affected by a revision. The revision of depreciation only affects future depreciation expenses.7.12 Recording depreciation expenses When depreciation is to be recorded, a Depreciation Expense account is debited, and Accumulated Depreciation is credited. Accumulated Depreciation is a contra-asset account that decreases the value of plant assets. The use of a contra-asset account allows assets to be shown at cost, and thus allows easier computations if a revision is necessary or different depreciation methods are used. When an asset is sold, all accounts related to the depreciation of that asset are adjusted.7.13 Capital & revenue expenditures Expenditures on fixed assets fall into two categories:  Capital expenditures: these increase the productive capacity, efficiency or useful life of an asset, and  Revenue expenditures: these include maintenance and repairs. If expenditure increases the efficiency or capacity of a fixed asset, that fixed asset account is debited. If expenditure increases the useful life of a plant asset, the accumulated depreciation account is debited. Revenue expenditures are expensed in the year incurred.7.14 Disposing fixed or non-current assets Fixed assets can be disposed of by discarding, selling, or trading in for other assets. No matter, how fixed assets are disposed-off, the book value of the asset must be removed from the account. When an asset becomes completely useless, it is written-off from the (40/48)